Current Account Deficits Matter Less Than Assumed for Currency Markets
Published May 15, 2018
By Kirill Zimoglyad
Junior Portfolio Manager
Global Fixed Income, Cash and Currency
The relevance of current account balances is fiercely debated in international economic and policy circles: can structural current account deficits persist indefinitely? Is there a threshold at which they become unsustainable and do they matter at all? Amid rising concerns about possible global trade wars, these topics have become even more important, with some observers arguing that US current account concerns are driving dollar weakness. Our view is that current account deficits matter less for currency markets than is commonly assumed.
What is a current account?
A country’s current account measures its net trade in goods and services, net earnings on cross-border investments and net transfer payments. It is often used interchangeably with the term “trade balance”, though this refers specifically to a country’s net trade in goods and services. A current account deficit means that a country is importing more than it is exporting or, alternatively, saving less than it is investing.
Current account relationship to currency
Conventional wisdom often assumes that currencies associated with current account surpluses should appreciate relative to those with deficits. However, when we test this by constructing a naïve investment strategy that assumes the opposite scenario, it appears to be profitable (see Figure 1). The strategy remains long the three currencies in the G10 with the highest average current account deficits over the period (USD, AUD and NZD) and short those with the highest average surpluses (CHF, NOK and SEK). While uninvestable, given the forward looking nature of the average current account balance over the 18-year test period, this thought experiment suggests that, rather than benefitting from holding surplus currencies, investors might actually receive a risk premium for holding deficit currencies.
The relationship between the current account and the currency can be both positive and negative depending on the underlying macroeconomic story and the nature of any economic shock. For example, a higher current account surplus driven by a positive external demand shock (higher exports) tends to lead to stronger growth, higher domestic inflation and a stronger currency. On the flip side, a higher current account surplus driven by weak domestic demand (lower imports) typically coincides with a weaker currency.
Where there is a current account deficit, it is important to dig deeply into the nature of the imbalance on a case-by-case basis. A deficit run by a “young” economy (e.g., Australia or India) to fund investment is not equivalent to a deficit run by a “mature” economy (e.g., the US or the UK) to fund consumption. Deficits run for investment purposes are indicative of a higher potential growth rate and should have less effect on foreign exchange rates than a deficit run to fund consumption.
Finally, current account balances should not be studied in isolation: in the balance of payments, current accounts are offset by capital accounts – a measure of net monetary flows between countries. In today’s era governed by financial flows, capital account transactions are a lot more telling for foreign exchange. They are far larger, more volatile and price sensitive than trade flows; they can change rapidly with risk tolerance and the outlook for growth, while trade flows are highly persistent. Furthermore, current account flows (of which trade flows are part) are subject to measurement error, dramatic revision and potential manipulation by officials. Therefore, it is the volatility of capital accounts that currency markets tend to react to.
Current accounts in investment models
All of this makes it difficult to create an investment process around current accounts. They must be studied in the context of broader balance of payments considerations, their main drivers, the duration of a country’s economic cycle and any data issues. We are exploring different options to incorporate current account figures into our investment process. Currently, our value and multi-factor fundamental inputs indirectly capture the factors that form “structural” current account balances. The structural current account balance is implied by the evolution of macroeconomic variables such as terms of trade, productivity, demographics, fiscal balances etc. Our models suggest that there is a more consistent relationship between structural current account balances and currency valuations, than between headline current account information and currency moves. For current account surpluses or deficits to matter to investors, therefore, they need to be examined in the right way.
G10: a generally accepted collective term for the currencies of ten advanced economies: USD, EUR, JPY, AUD, NZD, NOK, SEK, CHF, GBP and CAD
Long (or long position): The buying of a security such as a stock, commodity or currency with the expectation that the asset will rise in value.
Short (or short position): The selling of a security - or borrowing it and selling it - hoping for a decline in the market price so that it can be bought back at a cheaper rate.
The views expressed in this material are the views of Kirill Zimoglyad through the period ended May 8, 2018 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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